In the Postcrisis Era, Are Markets for Credit Derivatives Better at Reducing Risks? A Look at Settlement Cycles Suggests There Is Room for Improvement

Of all the risks facing financial markets, systemic risks can't be ignored. Given the right circumstances, the emergence of a systemic risk can destabilize markets, affecting all (or nearly all) securities at once, as happened during the 2008 financial crisis. At that time, the market for derivatives such as credit default swaps had ground to a halt, unable to absorb the sea of defaults overwhelming credit markets.

Washington's response to the crisis was twofold: heighten the regulatory oversight of the over-the-counter derivatives market and encourage more clearing - the process of paying for and settling transactions - through central counterparties (CCPs). The intention was for all institutions to clear all derivatives exposures with a single agent (a CCP). Doing so would dissolve the complex web of excess exposures that characterized the market and thereby eliminate the market's implicit fragilities.

To assess whether centralized clearing has indeed brought about such improvements, three economists looked closely at derivative transactions among large banks. Their goal was to better understand how these trades affect systemic risk. In their paper, "Unintended Consequences of Regulating Central Clearing," they identify the predominant trading patterns for derivatives and describe how such patterns contribute to (or detract from) the system's stability. "The patterns of clearing matter just as much as the amount of clearing," write Pablo D'Erasmo, Selman Erol, and Guillermo Ordoñez.¹

Securities markets can be remarkably complicated. Institutions are linked to each other through financial instruments that are intertwined in ways that can appear knotty and opaque to outsiders. The trading environment for derivative contracts is no exception, but for the sake of simplification, it helps to think of market participants (the authors focus on banks with a big Wall Street footprint) as forming a chain: One bank depends on another to fulfill its obligations, that other bank depends on yet another bank to make good on its obligations, and so on. If market participants perceive any link in the chain as malfunctioning, the entire chain is at risk, particularly because negative sentiment spreads quickly - and, at its worst, can morph into a systemwide crisis.

A centralized clearing system is meant to decrease the risk of a widespread financial implosion. But as attractive as it is in theory, real-world considerations limit its adoption. The sheer size and diversity of financial markets is but one headwind. How do you fashion a platform that accounts for all possible combinations of traders and securities? With this vast landscape in mind, the authors consider many different scenarios when modeling market behavior. Specifically, they measure outcomes according to different types of financial institutions and different ways of routing derivative contracts.

For their analysis, they thoroughly account for clearing patterns observed from the first quarter of 2015 through the fourth quarter of 2022, and they use a data set that "provide[s] a comprehensive picture of derivative activity for most banks in the U.S. . . . " They pay particular attention to so-called core banks, which are responsible for more than 80 percent of outstanding derivative contracts. The risk exposure of these large banks - which trade with a wide range of counterparties - provides a reading on exposures systemwide.

The study reveals (among many other findings) a notable shift in clearing activity. Even after reforms were enacted, core banks cleared outside of central channels much of the time, while peripheral banks increased their clearing activity through centralized counterparties. The authors argue that this suggests a decoupling: Peripheral banks and core banks cleared trades differently. "Regulations induced an increase in central clearing," the authors write, "but the increase is mostly explained by banks outside the core . . ." It follows, then, that in the aggregate, the derivatives market might not be less risky than it was before the crisis. With peripheral banks using centralized clearing more often than before, the effects of failed derivative contracts can be more easily transferred from a peripheral bank to a core bank, and the core bank can then quickly pass it on to other banks (given the core bank's prominence in trading activity). This contagion, according to the authors' modeling, appears to accelerate in a postregulatory environment.

Why are core banks slow to adopt central clearing? One possibility is their wish for privacy. Core banks that use centralized clearing must disclose trade information. This information might provide competitors with clues about a bank's book of business (that is, its trading volume, client base, concentrated positions, and other information that traders prefer not to share). The resulting decoupling, the authors say, "is consistent with an increase in systemic risk," and it "highlights the need for regulations that incentivize core clearing, not periphery clearing."

The derivatives ecosystem is a remarkably diverse community of financial institutions, investment products, and regulatory requirements. Because of its countless combinations of transactions and counterparties, identifying its vulnerabilities is challenging. But the authors show that by looking rigorously at different scenarios and mapping different outcomes with precision, we further our understanding of derivatives markets, uncovering new ideas about how to manage risk.